What is a Balance Sheet?

Accounts and Bookkeeping

Date Published: October 2007

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The Balance Sheet

Even if you are no expert in accounting or bookkeeping, you may well have heard of a balance sheet. Accountants will use the term all the time when referring to a company´s accounts, and particularly so at the end of the financial year; the production of the balance sheet is in essence what your accountant will do for you year end.

So, what is a balance sheet and why is it given this name?

Double Entry Bookkeeping

To understand why a balance sheet is called a balance sheet we need to understand the basic principle underlying most accounting methods, and this is the double entry approach. At its simplest double entry means that wherever there is a transaction amount entered in one place in your accounts books, there is another equal but opposite amount in another place in your accounts books. In other words there will always be two entries made in your book for one transactional input - double entry!

One entry is always equal but opposite to the other, and hence a balance is always maintained. Look at it on the principle of a set of scales. The scales start off empty and are balanced. If you put 3 apples in one side and then three apples in the other side they remain balanced. Add one banana to each side and they still remain balanced. In accounting terms one side of these sets of scales is called ´credit´ and the other side is called ´debit´.

As a more practical example, lets assume that you sell a blue widget to a known customer for £100. To keep things more simple we´ll assume that you are not charging VAT. The customer orders a blue widget which you send to him together with an invoice. You have raised an invoice for £100, and in doing so this is a transaction that you enter into your books. However if we are to work on the double entry principle, then we need to add another transaction to balance this. In this instance we would add a transaction against out debtors account, i.e. we have put £100 into our sales pot which is on the credit side of our scales, and we have put £100 into our debtors pot which is on the debit side of our scales. This ensures that our books remain balanced. It also shows us that we have made £100 in sales, but that we are also owed £100; our customer has now become a debtor!

When our customer pays us for our widget, we enter our payment into our books. The two entries for the purposes of double entry are a £100 debit entry against our bank account, and a -£100 entry against our debtors account (so the debtors account will reduce by £100).

If you are charging VAT then there will be more than one transaction created for any invoice that you raise, since there will need to be a separate entry for the VAT amount that is to be charged, and there will also need to be an opposite entry somewhere else in your books to maintain the necessary balance. (This second entry is generally made into the ´VAT Control Account´).

So, double entry bookkeeping is used as a method of maintaining ´balance´ within your accounts.

The Balance Sheet Functions

The balance sheet has two main functions. Firstly it demonstrates that your accounts do in fact balance, which they should do if all transactions have correctly been double entered. This may of course not be the case, particularly for manually maintained books. This is where the term ´balancing the books´ comes from. Adjustments have to be made by finding where errors have occured and re-assigning transactions as necessary so that the balance sheet does in fact balance. The balance sheet therefore identifies if there is an error somewhere in your books - it won´t necesarily be immediately obvious where the error lies, but you´ll know there is a problem somewhere!

The second function of the balance sheet is to give you an overall view of where you money is (or isn´t). How this is displayed will depend on your Chart Of Accounts (see our article "What is a Chart of Accounts") and Nominal Ledger (see our article "What is a Nominal Ledger" for an explanation of what a nominal ledger is), but in general the balance sheet will show you how much you have made in sales, how much money you are still owed by clients, how much money you have spent in running your business, in terms of overheads and direct expenses, how much money you still owe to your creditors etc. In other words your balance sheet will show you how healthy your business is.

The production of your balance sheet may seem like a daunting task, but with proper accounting software all of the double entry is done in the background. To maintain your balance sheet all you need to do is raise your invoices and enter how much money you have received and when.

Comments

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